In this edition of PFGBEST Perspectives On Institutional Forex, we would like to revisit a topic that is not foreign to us: that is, China. We have written about some of the economic problems and challenges China faces as a nation and as a key player in the global economy.
These changes are affecting countries such as Australia, Canada, and the EU nations.
After the above-mentioned S&P downgrade, the U.S. debt ceiling debate, and the reemerging troubles that threaten to disband the EU, these currencies (and the various bodies that deal in currency monetary reserves) stand to also be profoundly impacted by China's implementation of inflation controls.
China's Struggle With Its Own Inflation Problem
We reported in May 2011 that China continues to struggle with its FX reserve management, a root of China's inflation bloat. Reviewing what we presented then:
China's monetary base is highly correlated with its growing levels of FX reserves as the CNY is essentially fixed to the USD. To keep this peg in place, the People's Bank Of China (PBOC) needs to sell CNY against the USD. But this creates liquidity in its domestic market, and in the process, stokes inflation. Since commodities are denominated in USDs, the weak dollar of late also makes commodities more expensive. Hence, China imports inflation when they import materials to build the goods they export.
Above-consensus inflation reports suggest the persistent need for further monetary tightening. The PBOC raised the RRR (Reserve Requirement Rate) for its largest banks to 21% and resumed sales of 3Y bills at 3.8% (an expensive way to suck liquidity out of the economy versus raising the RRR). Other larger problems in China persist.
- Inflated property prices: Chinese citizens have few options in which to invest their money outside of real estate. Bank deposit rates are set well below inflation (in real terms deposit rates are negative 3% and lending rates are slightly positive); the stock market is perceived as too risky and volatile (and rigged). Overseas investment is prohibited.
- Large, state-owned industries are heavily invested in real estate. Most of their loans have come from state-owned banks. China's authorities coerced the state banks to make the loans to fight the global recession which took hold in 2008.
- The Chinese government has also invested heavily in infrastructure and other projects, to the tune of 50% of GDP. But job creation has been anemic, growing just 1% a year. Job growth is key to keep stability in China and the communist party knows this well.
- Political unrest is also a concern after the events in Egypt, Tunisia, MENA and the Jasmine uprising. Keep in mind that growth in China fell by 2/3 after the Tiananmen Square protests in 1989 to 4%. Political unrest produced economic stagnation.
- In a little-noticed move after S&P warned this it might cut America's credit rating, Fitch said they might do the same to China...citing that they are worried about bailing out China's banks which are overlending against a backdrop of overpriced property. Fitch is not worried about China sovereign debt but instead a scenario where they would have to bail out the banks.
The PBOC raised the reserve requirement for banks for the fifth time this year after raising it 10 times in 2010; interest rates on deposits and loans have been raised four times since October 2010. Retail loans have halved since January 2010 and corporate loan growth is off by 30% in the last year. This tighter policy has resulted in a sharp decline in construction volume and property sales. Car sales are also lower by 20% and demand in China for material and raw commodities has fallen.
China has further tightened monetary policy since that May issue was published, with little success at stemming the inflationary pressures. And when China released its July CPI and its PPI data in early August, both showed gains that were higher than market expectations. CPI for July rose to 6.5%, a three-year high driven primarily by higher food prices. PPI in July came in at a lofty 7.5%.
Economic growth continues to weaken as the PBOC chooses to use a restrictive monetary policy to wean out inflation in the economy which is portrayed in the slowing GDP number of late.
China's restrictive money policy, implemented by the PBOC with limited success, has some thinking a change could be in the works; current policy is only hurting growth and employment prospects in the future.
Further rising labor costs and thin profit margins could become more pronounced if the global economic slowdown persists into the fall. Recent volatility in the markets also complicates matters as global economic conditions add another level of uncertainty.
External Factors Stemming From The Downgrade And Further European Debt Issues
China has continued to accumulate FX reserves at an extraordinary rate over the past few years. From June 2010 to June 2011, China's FX reserves grew by $750 billion. A lot of that was invested in the U.S. treasury market. Alongside that, China currently holds about a quarter of its reserves in the Eurozone.
China is concerned about the recent S&P downgrade on U.S. credit, but the real vulnerability to its reserves and its large treasury holdings is a possible QE3 in the weeks or months ahead. Since the FOMC in early August pledged to keep the benchmark interest rate close to zero through mid 2013, it pressures the USD for an extended period. A weaker dollar is a disadvantage to foreign holders of U.S. treasuries as their USD holdings become discounted. A weak dollar could increase inflationary pressures all around the globe and that would lead China to tighten further, thus slowing its own growth prospects.
Political risks as portrayed by the U.S. debt ceiling debate also heighten concerns in Beijing.
And, Europe poses significant concern for China due to distressed debt of the PIIGS. An economically weak Europe is not in China's interest to put it mildly. The 27-member EU bloc is China's largest trade partner, and growing at a precipitous clip. Chinese exports to the EU rose 19% from 2009 to 2010. Buying European debt has also allowed China to diversify its reserves away from the U.S., which has helped support the Euro. Chinese exporters rely on a firm Euro in order to remain competitive.
Chinese Currency And Reserve Reform
A Financial Times article on Aug. 4, 2011 titled China can Break Free of the Dollar Trap, cited Yu Youngling, a former member of the PBOC monetary policy committee explaining that China is worried about a default coming from the recent downgrade in the U.S. that would bring large losses to China.
China currently holds 12% of U.S. debt.
The FT source went on to explain that China's reserve policy has failed because they did not address the real cause of the rapid increase in foreign exchange stocks, namely state intervention aimed at controlling the pace of renminbi appreciation. The question is: what losses is China willing to bear in its foreign exchange reserves in order to slow the pace of the renminbi appreciation?
In other words, China has been recycling reserves back into dollars in order to keep the renminbi weak and exports competitive. He goes on to recommend that China must stop buying U.S. dollars and allow the renminbi exchange rate to be decided by market forces as soon as possible. China should have done so a long time ago. There should be no more hesitating and dithering. To float the renminbi is not costless. However, its benefits for the Chinese economy will vastly offset those costs, while being favourable to the global economy as well.
Note the reaction in the FX market shortly after the article appeared in the graphs below!
Economic Reform In China
Austerity initiatives by the European governments and U.S. budget cuts are likely to place additional stress on Chinese export industries hampering economic growth and further aggravating the employment situation. China has long realized it needs to change its economy from being highly export-oriented to improving internal consumption. Officials there have a long-term intent to let the renminbi float when it is in Chinas best interest to do so, and without pressure from Washington or Brussels. The renminbi has been unusually strong the past few weeks and has been trending higher. Some FX analysts interpret that as a signal of significant change in China's reserve management and currency policy.
A strong renminbi makes imports cheaper, which would help quell inflation. That is good for Chinese consumers. Conversely, it will make Chinese exports more expensive which could make some of their industries less competitive. Overall, many agree that a stronger yuan has many advantages which would make China more competitive over the long term. As the transition to a consumer-led economy takes hold, China's current vulnerabilities to external shocks will be mitigated, giving its economy a more sustainable growth path.
Prime Minister Wen has said many times in the past that he intends to make China a consumer society and a stronger yuan should help this transition. With this in mind, it is important to point out that Chinese leaders are historically fearful of change and this transition is no different.
The Chinese authorities prefer a slow, deliberate and gradual approach to change which is not likely in the short term. Additionally, Chinese leaders refrain from doing anything that could cause disruptions in the present environment for fear that it could undermine the authority of the ruling Communist party.
These potential changes all come at a time when 30 years of high-growth rates in the economy could be showing signs of slowing. The current global economic environment has been challenging for China. Weaker growth, reduced demand, higher commodity prices and inflation have all combined to make a difficult environment more arduous.
Afterthoughts And Conclusion
The Japanese earthquake, the Arab Spring, higher commodity prices, the Eurozone debt crises, and American fiscal issues have all contributed to a large increase in risk aversion. Equities are 5% off their highs for the year. Economically, the world is slowing. The major industrialized countries including the U.S., Japan and the UK are just barely growing and the faster-growing emerging market, all heavily dependent on exports, are showing a slower trend. Commodity-rich countries like Australia and Canada are also experiencing anemic growth of late.
Currency depreciation or competitive devaluations could become the new norm as countries look for ways to stimulate growth through exports. Switzerland and Japan have implemented strategies to weaken their currencies recently. The yen and the franc traded to historical highs in August on safe haven and risk aversion flows. These developments also have some wondering if others will follow; that could spark a currency war, especially in the emerging countries which are so dependent on exports. One must remember that relying on currency exchange rates to influence exports is a zero sum game and will fail the global economy in the end.
China's move to let the yuan price band expand comes at an uncanny time when other seem to be moving in the opposite direction. It will be extremely interesting to see whether China stays the course as it works (so far, in vain) to solve its inflation problem and strives to implement adjustments to its economic model.
There is a substantial risk of loss in trading commodity futures, options, and off-exchange foreign currency products. Past performance is not indicative of future results.